REPORT OF THEJOINT SUBCOMMITTEE STUDYING

Proposed Modificationsto theUniform Commercial Code

ITO THE GOVERNOR ANDTHE GENERAL ASSEMBLY OF VIRGINIA

HOUSE DOCUMENT NO. 84 .

COMMONWEALTH OF VIRGINIARICHMOND1994

MEMBERS OF SUBCOMMITTEE

Delegate George H. Heilig, Jr., ChairmanDelegate Clifton A. Woodrum

Delegate J. Randy ForbesDelegate Willard R. FinneySenator Edward M. Holland

Senator Thomas K. Norment, Jr.

STAFF

DIVISION OF LEGISLATIVE SERVICES - Legal and Research

Arlen K. Bolstad, Senior AttorneyMary P. Devine, Senior Attorney

Cynthia G. Liddy, Executive Secretary

Administrative and ClericalAnne R. Howard, Committee Clerk, House of Delegates

Table of Contents

PageI. Introduction............................................................................................ 1

II. vee Article 6; The Bulk Transfers Act , 2

III. Proposed Revisions to uee Article 8; Securities 3

IV. Conclusion......... 4

V. Appendix 5

1. House Joint Resolution No. 524...................................................... A·l

2. Summary: Revision or repeal ofUCe·Article 6; Bulk Sales A·2

3. Summary: Revised DCC Article 8;Investment Securities A-6

Report of the Joint Subcommittee Studying ProposedModifications to the Uniform Commercial Code

ToThe Governor and the General Assembly of Virginia

Richmond, Virginia1994

To: The Honorable George Allen, Governor,and

the General Assembly of Virginia

I. INTRODUCTION

The 1993 General Assembly passed House Joint Resolution 524 (Appendix1), continuing a joint subcommittee of the House of Delegates and the Senatereviewing proposed modifications to the Uniform Commercial Code. The jointsubcommittee, composed of members from the House Committee on Corporations,Insurance and Banking and the Senate Committee on Commerce and labor,continued the work of its predecessors: examining revisions to the UniformCommercial Code proposed by the National Conference of Commissioners onUniform State Laws ("the Conference").

The following General Assembly members were appointed to the jointsubcommittee: Delegates Heilig of Norfolk, Woodrum of Roanoke, Forbes ofChesapeake, and Finney of Rocky Mount, and Senators Holland of Arlington andNorment of Williamsburg. Delegate Heilig served as chairman of the jointsubcommittee.

The joint subcommittee met in Richmond at the General Assembly Buildingon December 14, 1993. It received comments on the Conference's proposals torepeal or revise DCC Article 6, the Bulk Transfers Act, from Virginia'sCommissioner to the Conference, and from the Chairman of the Virginia BarAssociation's DCC Subcommittee. The Article 6 issue was before the jointsubcommittee in 1992 when it recommended repeal. A repealer bill was introducedin the 1993 General Assembly session, but was not reported out of committee.

The HJR 524 joint subcommittee recommended that a repealer bill beintroduced in the 1994 Session along with a bill substantially amending Article 6,the Conference's alternate proposal. The joint subcommittee concluded that bothoptions should be presently to the General Assembly for its consideration.

The joint subcommittee also received a general overview of DCC Article 8(Securities) revisions proposed by the Conference. Virginia's Commissioner to theConference advised the joint subcommittee that the proposed revisions are intendedto address an area of significant concern to the federal Securities and ExchangeCommission (SEC). The SEC has reportedly indicated its intent, pursuant to thefederal Market Reform Act of 1990 (prompted by the stock market crash of 1987 andthe demise of Drexel Burnham, a major brokerage firm), to adopt regulationspromoting uniform liquidity standards in securities sales clearance and settlementsystems -- unless comparable uniform state laws are adopted.

The Article 8 drafting committee, slated to meet in January 1994, may havea draft ready for submission to the American Law Institute in May 1994.Thereafter, the draft will be considered by the Conference at its annual meeting inAugust 1994. The joint subcommittee was advised, however, that it is uncertainwhether a Conference-approved draft will be ready for General Assembly action in1995.

II. DCC ARTICLE 6; THE BULK TRANSFERS ACT

The Bulk Transfers Act (Va, Code § 8.6-101 et seq.) requires merchants togive notice to the.ir creditors prior to selling their business inventory in a singletransaction, i.e., a "bulk sale." Bulk sales frequently occur" when a business is soldor discontinued. The Bulk Transfers Act ("the Act") is designed to discouragemerchants from making bulk sales and failing to pay their creditors. The Actrequires notice to creditors before such bulk sales are consummated, empoweringcreditors to void sales not conforming to the Act's requirements.

The Conference concluded that in today's commercial environment, the Actserves little useful purpose. Near-instantaneous credit checks assist manufacturersand other vendors in assessing the creditworthiness of merchants desiring topurchase business inventory on credit. Additionally, the widespread availability of"long arm" statutes and "uniform recognition of judgment" laws makes it virtuallyimpossible, in most cases, for individuals intent upon defrauding creditors to useinterstate movement as a means of evading state courts' jurisdiction or judgments.

Moreover, inventory financing under DCC Article 9 (Secured Transactions)may have displaced Article 6 as the protection of choice for manufacturers andwholesalers who sell inventory on credit. This attitude may be reflected in thedecision of at least 16 other states to repeal Article 6. To date, a handful of stateshave taken the alternate route suggested by the Conference and adopted theConference's Article 6 revision. A Conference position paper discussing the twooptions is attached as Appendix 2.

The uec subcommittee of the Virginia Bar Association's Business Lawsection did not recommend the revision's adoption when Article 6 was examined by

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the joint subcommittee in 1992. The Bar committee reiterated its opposition to therevision before the 1993 joint subcommittee, recommending that the GeneralAssembly repeal the article. A more extensive discussion of the Bar committee'sposition on this issue can be found in the 1992 joint subcommittee's final report(House Document 44 of 1993).

The joint subcommittee reviewed the following options: (i) making no changeto existing law, (ii) adopting the Conference's revision to Article 6, or (iii) simplyrepealing Article 6 altogether. Unable to reach consensus, the joint subcommitteerecommended that its staff prepare two bills for introduction in the 1994 Session ofthe General Assembly: one to repeal and one to amend.

III. uec ARTICLE 8: SECURITIES.

According to the Conference, revisions to Article 8 are necessary because thearticle does not adequately deal with the system of securities holding throughsecurities intermediaries that has developed' in the past few decades. Article B'sprovisions, to a large degree, correlate securities ownership with possession anddelivery of actual share certificates. However, most securities transfers today arelittle more than accounting entries on the books of securities intermediaries, i.e.,brokerages and depository institutions.

To bring Article B into the modern world of securities trading, theConference's Article 8 revision incorporates a new concept known as "securitiesaccount entitlement" to draw together the rights of investors who hold securitiesindirectly through financial intermediaries. The draft describes the rights ofholders of such "entitlements" and the obligations of financial intermediaries. Inanother significant revision, rules governing the creation' and perfection of securityinterests in securities have been removed from Article 8 and placed in Article 9.Additionally, a new section has been added in Article 9 providing special priorityrules for security interests in securities and securities account entitlements. AConference summary of the Article B issues is attached as Appendix 3.

The Article 8 drafting committee, slated to meet in January 1994, expects tohave a draft ready for approval by the American Law Institute in May 1994.Thereafter, it is expected the draft will be considered by the Conference at itsannual meeting in August 1994. It could not be determined at the time of the jointsubcommittee's meeting whether a Conference-approved draft would be ready forGeneral Assembly action at the 1995 Session.

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IV. CONCLUSION

The joint subcommittee had no further business before it and, accordingly,directed that its recommendations and proceedings in 1993 be reported to theGovernor and the 1994 Session of the General Assembly.

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v. APPENDIX

1. House Joint Resolution No. 524

2. Summary: Revision or repeal ofUCe Article 6; Bulk Sales

3. Summary Revised DeC Article 8; Investment Securities

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APPENDIX 1

GENERAL ASSEMBLY OF VIRGINIA··1993 SESSIONHOUSE JOINT RESOLUTION NO. 524

Continuing the Joint Subcommittee Studying Proposed Modifications to the UniformCommercial Code.

Agreed to by the House of Delegates, February 7, 1993Agreed to by the Senate. February 23, 1993

WHEREAS, the Uniform Commercial Code has been adopted in 49 states, the District otColumbia. and the Virgin Islands; and

WHEREAS, the National Conference ot Commissioners on Uniform State Laws hasadopted revisions to various articles of the V.C.C. and is considering additional revisions toupdate the V.C.C.; and

WHEREAS, the 1988, 1989, 1990 and 1992 Sessions of the General Assembly. pursuant toHouse Joint Resolutions 59, 248,15 and 147, respectively, established and continued a jointsubcommittee to study U.C.C. modifications proposed by the National Conference; and

WHEREAS, the joint subcommittee recommended adoption of new U.C.C. articles andrevisions to existing articles, and such recommendations were enacted by recent sessions otthe General Assembly; and

WHEREAS. the National Conference continues to develop revisions to existing articles,responding frequently to changes In commercial practices, technological innovations, andevolving regulatory practices: and

WHEREAS, the National Conference's revision ot U.C.C. Article 8 (investment securities)will be available for legislative review and study in June 1993; and .

WHEREAS. the need for continued uniformity in the area of commercial law is great;now, therefore, be it

RESOLVED by the House of Delegates, the Senate concurring, That the JointSubcommittee Studying Proposed Modifications to the Uniform Commercial Code proposedby the National Conference be continued.

The joint subcommittee's current membership shall continue to serve. Vacancies shallbe filled by the Speaker of. the House or the Senate Committee on Privileges and Elections,as appropriate. The business law sections of the State Bar ot Virginia and the Virginia BarAssociation are requested to assist in the study,

The indirect costs of this study are estimated to be $5,860; the direct costs of this studyshall not exceed $1,800.

Implementation of this resolution is subject to SUbsequent approval and certification bythe Joint Rules Committee. The Committee may withhold expenditures or delay the periodfor the conduct of the study.

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essential protection for creditors to unnecessarybur­den for "bulksale" buyers.

. It was Dot clear, however, that repeal was or is auniform solution or a uniformly acceptable recom­mendation in every state and jurisdiction. So the

.Revised Article 6 of the uce is provided in the al­ternative. Alternative A offers the states the optionof repealing thewholeof Article 6. Alternative B of­

fers a revised and updated Article 6 to those statesand jurisdictiODS that will evaluate the positions ofcreditors, sellers, and buyers, and then decide [0

retain a bulk sales law.How is UDiformity to be served and maintained

whenstates are given these alternatives? The lawofthe seller's place of business controls the choice ofJaw. If the seller in a bulk sale hashis or her place of

business in a state in which Article 6 has beenrepealed, then there isDObulksales Jaw applicable tothe sale. If the state does have Revised Article 6, itapplies. No conflict situation should arise.

Revised Article 6, if repeal is not chosen,remedies the problems of the original, It minimizesthe burdens placed upon the bulksale buyer. The ob­ject is to pinpoint the creditor's risk and to narrowt:he reach ofthe statute to cover thatrisk and no more.Much improvement accrues through the definitionsof such terms as "assets", "bulk sale", "date of bulksale", and the like, all of which increase the certaintyofRevisedArticle 6. Noneof these terms are definedat all in the originalArticle 6. A "bulk transfer"underoriginal Article 6 took place with the transfer Ifof amajor part of the materials,supplies, merchandise orother inventory" outside the ordinary course of busi­ness. RevisedArticle 6 defines "assets" as "inventorythat issubject of a bulk sale and any tangible and in­tangible personal property used or held for useprimarilyin, or arisingfrom, the sellers businessandsold in connection with that inventory. '." The reachof Article 6 is more clearly confined in Revised Ar­

ticle6.

APPENDIX 2

~OmMCOMMrnRC~CODE

REVISED ARTICLE 6 - BULK SALES

-ASwnmary ­

Aticle 6 of the Uniform Co~ercial Code (UCC)providesa specific kind of protection for creditors ofbusinesses that sell merchandise from stock.Creditors of these business are vulnerable to a "bulksale", in whichthe business sells all or a large part ofinventoryto a singlebuyer outside the ordinary courseof business, following which the proprietor abscondswith the proceeds. Original Article 6 of the uec re­quires "bulk sale" buyers to provide DOtice to thesellers creditors and to maintain a list of sellerscreditors and a schedule of property obtained in a"bulk sale" for six months after the "bulk sale" takesplace. Unless these procedures are followed,creditors mayvoid the sale. Auctioneers, who handlemerchandisein buJk, arc givena similarburden to thatof "bulk: sale"buyers.

Article 6 replaced a variety of earlier bulk saleslaws in the states. All were enacted in a climate ofsmaller businesses that were localized in scope.These laws protected local business creditors fromliq uidatioas that might take merchandise andproceeds beyond these creditors' ability to obtain aremedy. Article 6 introduced the salubrious qualityof uniformityto these protections for creditors.

But the credit environment has changed, so thatthe risk of the abscondingmerchandiser is no longervery great. Business creditors can evaluate credit­worthinessfar better thanwas the casewhenthe uecwas first promulgated, and theycan pursue abscond­ing sellers with much lessdifficulty. Further, modemfraudulent transfer actions under the UniformFraudulent Transfer Act overlap Article 6 in a sig­nificant way. Sophisticated and widespread inven­tory financing under Article 9 of the vec, which

provides even more significant protections forcreditors, simplyby-passes Article 6 protections. In1988,as revisions of Article 6 were being considered,a considerable body of opinionsupported the notionof repeal for Article 6. That body of opinion per­ceived that the balance of equities had swung from

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In Revised Article 6 a "bulk sale" takes place ifthere is a sale of "more than half the seller5 inveatory"

outside the ordinary course of business and under

conditions in which the "buyer has notice...thac the

seller will not continue to operate the same or a

similar kind of business after the sale". Again the

reach of Article 6 is limited and more clearly defmed

than under the original Article 6. The risk tocreditors arises from the sale in which the seller goes

out of business, so Revised Article 6 applies only to

those situations.

The notion oflimitations iscarried forward in the

extended exceptions provision in Revised Article 6.Certain kinds oftransfers are exceptedunder original

, Article 6. Any transfer that secures an obligation or

that is accomplished to satisfy an obligation is not

subject to original Article 6. A sale or transfer of abusiness that preserves existingcreditors' rightsisnot

subject to original Article 6. Revised Article 6 im­proves upon the existing exceptions with some new

notice requirements for buyers who will assume the

sellers debts.

Revised Article 6, also, exceptsfor the first timeanyassetsales that fallbelowa net valueof$10,000.00

or that exceed a value of $25,000,000.00. In neither

case is there a perceived need to burden the buyer

with the requirements of Article 6. The small

amounts constitute a nuisance, and the very large

"bulksale" can hardly be done in a manner unknownco creditors and, indeed, to the world.

What a buyer in a bulk sale does under RevisedArticle 6 is primarilythe same aswhat thatbuyerdoes­under original Article 6. The buyer obtains a list of

creditors (Wclaimants" under Revised Article 6) andprovides them with notice of the "bulk sale". The

notice requirements are different, however, under

Revised Article 6. If the seller provides a list of 200or more claimants, or provides a verified statement

that there are more than 200, the buyer satisfies the­

notice requirement by filing a written notice of the"bulksale" with the office of the Secretary of State (or

other applicable official, as a state provides) rather

than by giving written notice to all claimants. One of

the great burdens to buyers under original Article 6

is individual notice to large numbers of creditors.

Revised Article 6 simplifies the process.Revised Article 6, also, provides for a different

array of information that is kept for creditors (or

claimants). Under original Article 6, the buyer kept

a schedule of property and a list of claimantsfor a sixmonth period following the sale. These are not re­

quirements of Revised Article 6. Instead, the seller

and buyer must agree on the net contract price to be

distributed, and [hen must set forth "a written

schedule of distribution". The "schedule of distribu­tion" may provide for any distribution that the seller

and buyer agree to, "including distribution of the en­

tire net contract price to the seller." The schedule of

distribution accompanies any notice given to

claimants, however given.

The last significant change from the originalAr­

ticle6 in Revised Article 6 is the basic remedy avail­able to creditors. In original Article 6, the creditor

voids the sale. Revised Article 6 provides for money

damages rather than for voiding the sale. The

creditor is entitled to damages for noncompliance in

an amount to equal his or her real losses. There are

cumulative limits on the damages that may be as­

sessed, and buyers are given the defense of "good

faith" efforts to comply with Article 6.

Auctioneers and liquidators continue to be

covered by Revised Article 6. Those who conduct

auction salesand liquidationsales are treated as "bulk

sale"buyers,and must provide notice [0 claimantsas"bulksale"buyersarerequired to do. The notice fonn

is different and tailored to auction or liquidation

sales.Revised Article 6 extends the statute of limita­

tions on creditors actions from six months [0 oneyear. OriginalArticle 6 provided for six months. The

period runs from the date of the "bulk sale", Con­

cealed sales toll the statute of limitations in Revised

Article 6, as they do under original Article 6.

Repeal or revise are the options offered to the

states in the Revised Article 6 of the vee. Repeal is

the preferred option, but the revisions in Alternative

B eliminate the significant difficulties encountered

under original Article 6, and make them an excellent

alternative to repeal.

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Why states should revise Article 6 of theUniform Commercial Code

Bulk sales lawswere originally drafted in response to a fraud perceived tobecommonaround the turn of the century: amerchant wouldacquire hisstockin trade on credit, then sell the entire inventory("in bulk")andabscond with theprofits, leaving creditors unpaid.

Article 6 was drafted as a response to this "bulk sale risk." It affordscreditors a remedy against a good faith purchaser for full valuewithout noticeof any wrongdoingon the part of the seller. In the legal context in which AI­ticle 6 was drafted, the benefits to creditors appeared to justifythe costs of in­terfering with good faith transactions.

Present Article 6 imposesseveralduties OD the buyer in bulk. These dutiesinclude the dutyto notifythe creditors of the impending bulk transfer. This canbeburdensome, particularlywhen the seller has a large number of creditors.

The Article requires compliance even when there is no reason to believethat the seller isconducting a fraudulent transfer, aswhen the seller isscalingdown the business but remaining available to creditors. And it also imposesstrict liabilityfor noncompliance. Failure to complywith the provisionsof theArticle renders the transfer ineffectivet even when the buyer has complied ingood faith, and even when DO creditor has been injured by the'noncompliance.

The current revisionofArticle6 isdesigned to reduce the burdens and risksimposed upon good-faith buyersofbusinessassets while increasingthe protec­tion afforded to creditors.

Among the aeededchanges are:

- Article 6 applies only when the buyer has notice that theseller will not continue to operate the same or a similar kindof businessafter the sale;

- when the seller is indebted to a large number of creditors,the buyerdoes not haveto send individualnotice to everyper­son, but instead maygivenotice by filing;

- a buyer who makes a good faith-effort to complywith therequirements of Article 6 is not liable for noncompliance.

Present Article 6 has become iaadequate to regulate modern bulk sales.The revised Article is designed to afford better protection to creditors whileminimizing the impediments to good-faith transactions.

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Why states should repeal Article 6 of theUniform Commercial Code

Bulksales lawswere originally drafted in response to a fraud perceivedtobe common around the turn of the century: a merchant would acquire his stockin trade on credit, then sellhisentire inventory ("inbulk") and abscond with the'proceeds, leaving creditors unpaid.

Article6 wasdrafted asa response to this"bulksale risk." It imposesseveraldutieson the buyer in bulk, including the dutyto notify all creditors of the im­pendingbulktransfer. It alsorequires compliance even.wnen there is no reasonto believe that the seller is conducting a fraudulent transfer. The Article im­posesstrict liability for noncompliance. Failure to comply with the provisionsrender the traasfer ineffc;ctivet evenwhen the buyer has compliedingood f~th.

But todaYt clwJges in thebusinessand legalcontextsinwhichsalesare con­ducted have made repJatioD of bulk saJes UDIIec:essary. Creditors are betterable to make informed dccisioas aboutwhether to extend credit. Changes intechnology haveeDabled credit reportingservices to providefast,accurate, andmore complete credithistoriesat relatively small cost.

Creditors also haw greater opportuDity to collect their debts. The adop­tion of state long-arm statutcs and rules have greatly improved the possibilityof obtainingpersonal jurisdictionover a debtor who flees to another state.

And creditors no longer face the choiceof extendingunsecuredcredit orDO aedit at all Retaininganinterest in inventory to secure itspricehasbecomerelatively simple and iDexpeDSive ~der Article 9 of the vee· adopted in 49states. Ifa bulksale isfraudulentand~e buyerisa partyto the fraud,Creditorshave remediesunder the Uaiform FraudulentTransfer Act.

There isDOevidencethat in today'seconomy, fraudulentbulksalesare fre­quent enough,or engender credit lossessignificant enough, to require regula­tionofallbulksales.including the vastmajority thatare conductedingoodfaith.

The Unilorm LawCommissioners, therefore,encourage those states thathave enacted Article 6 to repeal it.

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APPENDIX 3

1 UNIFORM COMMERCIAL CODE2 REVISED ARTICLE 8. INVESTMENT SECURITIES

3 PREFATORY N·OTE

4 1. HISTORY OF THE ARTICLE 8 REVISION

5 A. Drafting History

6 In the Spring of 1991, the National Conference of Commissioners on7 Uniform State Laws formed a Drafting Committee to Revise Uniform8 Commercial Code Article 8-Investment Securities. The current project to9 revise Article 8 comes in response to expressions of concern from various

10 sources that the present structure of Article 8 may be inadequate to deal with11 recent developments in securities holding and"trading practices.

12 In several of the studies issued after the October 1987 stock market·13 break, It was suggested that uncertainties about the application of the Article 814 rules to securities held through intermediaries, particularly the rules governing15 perfection of security interests in securities so held, might have adversely16 affected the willingness of financial institutions to provide essential financing to17 securities firms in periods of market disturbance. At the suggestion of the18 Securities and Exchange Commission, the Business Law Section of the ABA19 formed an Advisory Committee on Settlement of Market Transactions to20 undertake a study of possible revisions of Article 8 and related provisions of21 bankruptcy law. In February of 1991 the ABA Committee issued an Interim22 Report, making tentative recommendations for revision of Article 8 and various23 provisions of the federal Bankruptcy Code.

24 At the same time that the ABA Committee was at work, Congress was25 considering various legislative packages for amendments to the securities laws in26 response to the October 1987 market break and the failure of Drexel Burnham27 in February of 1990. Included in the legislation adopted as the Market Reform28 Act of 1990, P.L. 101-432, was a provision, codified at 15 U.S.C. 78q-1(f),29 giving the Securities and Exchange Commission the authority to promulgate30 regulations preempting state law on the "transfer of certificated or uncertificated31 securities ... or limited interests (including security interests) therein; and the32 rights and obligations of purchasers, sellers, owners, lenders, borrowers, and33 financial intermediaries (including brokers, dealers, banks, and clearing34 agencies) involved in or affected by such transfers, and the rights of third35 parties whose interests in such securities devolve from such transfers. II The36 Act, however, provides that the SEC is to act only if it makes certain specified37 findings, after recommendations of an Advisory Committee and consultation

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1 with the Secretary of the Treasury and Board of Governors of the Federal2 Reserve System, to the effect that the absence of a uniform federal rule3 substantially impedes the safe and efficient operation of the national system for4 clearance and settlement of securities transactions. There is also a provision in5 the Act, 15 U.S.C. § 78q-l(f)(3), apparently added late in the legislative6 process, specifying that if the SEC promulgates such rules, a State can7 effectively "opt-out" by enacting legislation establishing rules differing from the8 federal rules.

9 In response to these developments, the Executive Committee of the10 National Conference of Commissioners on Uniform State Laws decided in the11 Spring of 1991 to form a Drafting Committee and directed the Committee to12 proceed as quickly as possible with the work of revising Article 8 to meet the13 needs identified in these various studies. The Drafting Committee has had14 numerous meeting since the Fall of 1991 to discuss drafts of Revised Article 8.15 A full draft was presented for a first reading at the Annual Meeting of the16 National Conference in August 1992. The American Law Institute has also17 begun the process of consideration of the draft, through a Members Consultative18 Group and an Ad Hoc Committee formed by the ALI Council, and draft will be19 presented to the Al.Imernbership at the May 1993 meeting. .

20 Because the Drafting Committee has been able to proceed rapidly21 toward promulgation of revised Article 8, and relevant provisions of Article 9,22 it appears that the goal of resolving the present problems within the framework23 of the Uniform Commercial Code is within reach. The two key bodies with24 authority to promulgate separate bodies of commercial law rules for particular25 sectors of the market -- the SEC and the United States Treasury -- are following.26 the Article 8 project closely. If the Article 8 project continues to progress27 rapidly, there is every reason to believe that neither the SEC nor the Treasury28 will find it necessary to exercise their authority to pre-empt state law. Although29 the SEC Market Transactions Advisory Committee ("MTAC tI

) is actively at30 work on studying a broad range of legal issues concerning securities clearance31 and settlement, while the Article 8 project is proceeding MTAC has decided to32 focus on revisions that might be needed in federal law, or other regulatory33 action that might be appropriate pending or even after a comprehensive revision34 of Dee Article 8. Many of the members of MTAC, including its chair and35 principal SEC representative, are also acting as advisors to the NCCUSL36 Drafting Committee. The U.S. Department of the Treasury has for some years37 been considering promulgation of revised regulations (the "TRADES"38 regulations) governing the book-entry system for federal government securities.39 Representatives of the Treasury and the Federal Reserve system have been40 working closely with the NCCUSL Drafting Committee from the beginning of41 the project, and have indicated that they share the hope of the Drafting42 Committee that revised Article 8 could provide a sound basis for the

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1 government securities market, so that it would not be necessary for federal2 regulations to establish a separate system of commercial law for government3 securities. On another front, it should be noted that representatives of the4 commodities industry and the CFTC have also been working closely with the5 revision project. The current draft implements the consensus reached in several6 meetings with the commodities representatives that although commodity futures7 contracts and commodity options should not be governed by Article 8, the new8 Article 9 security interest rules on security interests in securities should also9 apply to commodities, with some modifications.

10 The Drafting Committee and the Reporter have made special efforts to11 reach out to groups with interests in the matters covered by Article 8 both to12 learn the problems and needs of the securities business and to explain to the13 industry and the bar the approach taken in Revised Article 8. The Reporter has14 met with individual securities firms, banks involved in securities clearance,15 custody, and processing, domestic and foreign clearing corporations, mutual16 funds, transfer agents, and lenders to securities firms, as well as with industry17 organizations, including the Securities Industries Association, the Public18 Securities Association, the Securities Transfer Association, and the Investment19 Company Institute, and the New York Clearing House. Representatives of the20 relevant regulatory and other governmental agencies, including the SEC, the21 CFTC, and the Federal Reserve Banks, and the Treasury Department, have22 been following and participating in the" project. Contacts have also been23 established with representatives of the u.s. Working Committee of the Group of24 Thirty, an independent non-partisan, non-profit organization which is working25 with the industry to implement improvements in the clearance and settlement26 systems for securities trading in the United States and globally. The Reporter27 and others have also made presentations on the revision project at meetings of28 the American Bar Association, the Association of American Law Schools,29 various state and local bar associations and numerous continuing legal education30 programs. The project has also been publicized in the relevant periodicals,31 including the Business Lawyer, the vec Bulletin, the Commercial Law Annual,32 and the ABA uce Committee newsletter. As a result of these outreach efforts,33 the revision project has probably received as much or more attention as similar34 projects in recent years, despite the fact that it is proceeding on a relatively fast35 track.

36 The Reporter wishes to express gratitude to many within the industry37 who have been generous with their time in answering questions and assisting the38 Reporter and Drafting Committee inlearning about the clearance and settlement39 system. Any errors or inaccuracies in the description of securities practices40 contained in this draft are the Reporter's responsibility. The Reporter welcomes41 correction on such matters.

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1 B. Need for Revision of Article 8 -2 Evolution of Securities Holding and Trading Systems

3 The principal reason that revision of Article 8 is necessary is that4 present law does not adequately deal with the system of securities holding5 through securities intermediaries that has developed in the past few decades.6 Although present Article 8 does contain some provisions dealing with securities7 holding through securities intermediaries, these have been engrafted onto a8 structure designed for securities practices of earlier times. The resulting legal9 uncertainties adversely affect all participants. The revision seeks to provide a

10 modem legal structure for current securities holding practices.

11 L The Traditional Securities Holding System

12 The original version of Article 8 of the uec is based on the13 assumption that possession and delivery of physical certificates are the keyt14 elements in the securities holding .and trading system. Ownership of securities15 was traditionally evidenced by possession of the certificates. and changes were16 accomplished by delivery of the certificate.

17 The traditional certificate-based system of securities transfers was a18 complicated, labor-intensive process. Each time securities were traded, the19 physical certificates had to be delivered from the seller to the buyer, and 'in the20 case of registered securities, the certificates had to be surrendered to the issuer

·21 or its transfer agent for registration of transfer. As is well known, the22 mechanical problems of processing the paperwork for securities transfers23 reached crisis proportions in the late 1960s, leading to calls for the elimination24 of the physical certificate and development of modern electronic systems for25 recording ownership of securities and transfers of ownership. That was the26 focus of the revision effort that lead to the promulgation of the 197827 amendments to Article 8 concerning uncertificated securities.

28 2. The Uncertificated Securities System Envisioned by the 197829 Amendments

30 In 1978, amendments to Article 8 were approved to establish the31 commercial law rules that were thought necessary to permit the evolution of a32 system in which issuers would no longer issue certificates. The Drafting33 Committee that produced the 1978 amendments was given a fairly limited34 charge. It was to draft the revisions that would be needed for uncertificated35 securities, but otherwise leave the Articles 8 rules unchanged. Accordingly, the36 1978 amendments primarily took the form of adding parallel provisions dealing37 with uncertificated securities to the existing rules of Article 8 on certificated38 securities.

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1 The system of securities holding and trading contemplated by the 19782 amendments differed from the traditional system only in that ownership of3 securities would not be evidenced by physical certificates. It was contemplated4 that changes in ownership would continue to be reflected by changes in the5 records of the issuer. The main difference would be that instead of6 surrendering an indorsed certificate for registration of transfer, an instruction7 would be sent to the issuer directing it to register the transfer. Although a8 system of the sort contemplated by the 1978 amendments may well develop in9 the coming decades, this has not yet happened for most categories of securities.

10 Virtually all publicly traded corporate and municipal securities are still issued in11 certificated form. Individual investors who wish to be recorded as registered12 owners on the issuer's books still obtain and hold physical certificates. The13 certificates representing the largest portion of the shares, however, are not held14 by the beneficial owners, but by" clearing corporations. Settlement of securities15 trading occurs not by delivery of certificates or by registration of transfer on the16 records of the issuers or their transfer agents, but by notation on the records of17 clearing corporations and securities intermediaries. That is quite different from18 the system envisioned by the 1978 amendments.

19 3. Evolution of the Indirect Holding System

20 At the time of the "paperwork crunch" in the late 1960s, the trading21 volume on the New York Stock Exchange that so seriously strained the22 capacities of .the clearance and settlement system was in the range of 10 million23 shares per day. Today, the system can easily handle' daily trading volume on24 routine days in the range of 150 to 200 million shares. Even during the October25 1987 market break, when daily trading volume reached the current record level26 of 608 million shares, the clearance and settlement system functioned relatively27 smoothly. Obviously this processing capacity could have been achieved only by28 the application of modem electronic information processing systems, and that is29 the case. Physical delivery of certificates plays only a minor role in the30 settlement system that processes this enormous volume of securities trading.31 Yet the legal rules under which the system operates are not the uncertificated32 securities provisions of Article 8. To understand why this is so, one must delve33 at least a bit deeper into the operations of the current system.

34 If one examined the shareholder records of any large corporation whose35 shares are publicly traded on the exchanges or over the counter market, one36 would find that one entity -- Cede & Co. -- is listed as the shareholder of record37 of somewhere in the range of sixty to eighty per cent of the outstanding shares38 of all publicly traded companies. Cede & Co. is the nominee name used by39 The Depository Trust Company ("DTC"), a limited purpose trust company40 organized under New York law for the purpose of acting as a depository to hold41 securities for the benefit of its participants, some 600 or so broker-dealers and

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1 banks. Essentially all of the trading in publicly held companies is executed2 through the broker-dealers who are participants in DTC, and the great bulk of3 public securities -- the sixty to eighty per cent figure noted above -- are held in4 the names of these broker-dealers and banks on behalf of their customers. If all5 of these broker-dealers and banks held their securities themselves, then as trades6 were executed each day it would be necessary to transfer the securities back and7 forth among these broker-dealers and banks. By handing ail of their securities8 over to a common depository all of these deliveries can be eliminated. DTC's9 books break down the total number of shares of each security that it holds in the

10 aggregate into accounts for each of its participants. AlJ that needs to be done to11 settle each day's trading is for DTC to adjust the amounts shown in the12 participants' accounts.

13 Although the use of a common depository eliminates the needs for14· physical deliveries, an enormous number of entries would still have to be made15 on DTC's books if each transaction between its participants were recorded one16 by one on DTC's books. Any two major broker-dealers may have executed17 hundreds or even thousands of trades with each other in a given security on a18 single day. Significant processing efficiency has been achieved by netting all of19 the transactions among the major players that qcc.ur each day, so that entries20 need be made on the depository's books only for the net changes in the positions21 of each participant at the end of each day. This netting function might well be22 performed by the securities exchanges or by the same institution that acts as the23 depository, as is the case in many other securities markets around the world. In24 the United States, however, this clearance function is carried out by a separate25 corporation, the National Securities Clearing Corporation (NSCC).

26 The broker-dealers and banks who are participants in the DTC-NSCC27 system in turn provide analogous clearance and settlement functions to their own28 customers. If Customer A buys 100 shares of XYZ Co. through Broker, and29 Customer B sells 100 shares of XYZ Co. through the same Broker, the trade30 can be settled solely by entries on Broker's books. Neither DTC's books31 showing Broker's total position in XYZ Co., nor XYZ Co. 's books showing32 DTC's total position in XYZ Co., need be changed to reflect the settlement of33 this trade. One can readily appreciate the significance of the settlement function34 performed at this level if one considers that a single major bank may be acting35 as securities custodian for hundreds or thousands of mutual funds, pension36 funds, and other institutional investors. On any given day, the customers of that37 bank may have entered into an enormous number of trades, yet it is possible38 that relatively little of this trading activity will result in any net change in the39 custodian bank's positions on the books of DTC.

40 Settlement of market trading in most of the major securities markets is41 now effected primarily through some form of depository system. Virtually all

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1 publicly traded corporate equity securities, corporate debt securities, and2 municipal debt securities are now eligible for deposit in the DTC system.3 Recently, DTC has implemented a similar depository settlement system for the4 commercial paper market, and could, but for limitations in present Article 8,5 handle other forms of short-term money market securities such as bankers6 acceptances. For trading in mortgage-backed securities, such as Ginnie Mae's,7 a similar depository settlement system has been developed by the Participant's8 Trust Company. For trading in U.S. Treasury securities, a system somewhat9 analogous to the DTC depository system was put into place by the Treasury and

10 the Federal Reserve System in the mid-1970s. Treasury securities are genuinely11 "uncertificated, It that is, no paper certificates are issued. The holding system12 for Treasury securities, however, bears more resemblance to the DTe13 depository system than to the uncertificated system envisioned by the 197814 amendments to Article 8. In the Treasury system as in the DTC system, the15 records of ownership are maintained through a tiered system, rather than on a16 single set of records maintained by or on behalf of the issuer. The Federal17 Reserve Banks, acting as fiscal agent for the Treasury, maintain records 'of the18 holdings of member banks of the Federal Reserve System, and those banks in19 turn maintain records showing the extent to which they are holding for their20 own customers, including government' securities dealers, institutional investors,21 or smaller banks who in tum act as custodians for investors.

22 4. Need for Different Legal Rules for the Direct and Indirect Holding23 Systems' ,

24 Both the traditional paper-based system, and the uncertificated system25 contemplated by the 1978 amendments, can be described as "direct" securities26 holding systems, that is, the beneficial owners of securities have a direct27 relationship with the issuer of the securities. For certificated securities in bearer28 form, whoever has possession of the certificate thereby has a direct claim29 against the issuer. For registered securities, the registered owner, whether of30 certificated or uncertificated securities, has a direct relationship with the issuer31 by virtue of being recorded as the owner on the records maintained by the issuer32 or its transfer agent.

33 By contrast, the DTC depository system for corporate equity and debt34 securities, or the Treasury-Federal Reserve system for government securities,35 can be described as" "indirect holding" systems, that is, the issuer's records do36 not show the identity of all of the beneficial owners. Instead, a large portion of37 the outstanding securities of any given issue are recorded on the issuer's records38 as belonging to a depository. The depository's records in turn show the identity39 of the banks or brokers who are its members, and the records of those securities40 intermediaries show the identity of their customers.

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1 Even after the 1978 amendments, the rules of Article 8 do not deal2 effectively with the indirect holding system. The rules of Article 8 are based on3 the assumption that changes in ownership of securities are effected in either or4 both of two ways: delivery of physical certificates or registration of transfer on5 the books of the issuer. Yet in the indirect holding system, settlement of the6 vast majority of securities trades does not involve either of these events. For7 most, if not all, of the securities held through DTC, physical certificates8 representing DTC's total position do exist. These "jumbo certificates, It

9 however, are never delivered from person to person. Just as nothing ever10 happens to these certificates, virtually nothing happens to the official registry of11 stockholders maintained by the issuers or their transfer agents to reflect the12 great "bulk of the changes in ownership of shares that occur each day.

13 The principal mechanism though which securities trades are settled14 today is.not delivery of certificates or registration of transfers on the issuer's15 books, but accountingentries on the books of a multi-tiered pyramid of16 securities intermediaries through which investment securities are held. Herein17 in the basic problem. Virtually all of the rules of Article 8 specifying how18 change in ownership of securities are effected, and what happens if something19 goes awry in the process, are keyed to the concepts of a transfer of physical20 certificates or registration of transfers on the books of the issuers; yet that is not21 how changes in ownership are actually reflected in the modern securities trading'22 system.

23 II. SUMMARY OF REVISED ARTICLE 8

24 A. Drafting Approach

25 One of the challenges that the Drafting Committee faces in this project26 is devising a structure of commercial law rules for investment securities that27 will be sufficiently flexible to respond to changes in practice over the next few28 decades. If it were possible to predict with confidence how the securities29 holding and trading system would develop, the Committee could produce a30 statute designed specifically for the system envisioned. Recent experience,31 however, shows the danger of that approach. The 1978 amendments to Article32 8 were based on the assumption that the solution to the problems that plagued33 the paper-based securities trading system of the 19605 would be the development34 of uncertificated securities. Instead, the solution thus far has been the35 development of the indirect holding system.

36 If one thought that the indirect holding system would come to dominate37 securities holding, one might draft Article 8 rules designed primarily for the38 indirect holding system, giving limited attention to the traditional direct holding39 system of certificated securities or any uncertificated version of a direct holding

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1 system that might develop in the future. It is, however, by no means clear2 whether the long-term evolution will be toward decreased or increased use of3 direct holdings; At present investors in most equity securities can either hold4 their securities through brokers or request that certificates be issued in their own5 name. For the immediate future it seems likely that that situation will continue.6 One can imagine many plausible scenarios for future evolution. Direct holding7 might become less and less common as investors become more familiar and8 comfortable with book-~ntry. systems and/or as market or regulatory pressures9 develop that discouragedirect holding. One might note, for example, that

10 major brokerage firms are beginning to impose fees for having certificates11 issued and that some observers have suggested that acceleration of the cycle for12 settlement of securities traders might be facilitated by discouraging customers13 from obtaining certificates, On the other hand, other observers feel that it is14 important for investors to retain the option of holding. securities in certificated15 form, or at least in some form that gives them a direct relationship with the16 issuer and does not require them to hold through brokers or other securities17 intermediaries. Some groups within the securities industry are beginning to18 work on development of uncertificated systems that would preserve this option.

19 The Drafting Committee has adopted a position of neutrality toward the20 evolution of sec,uri ties holding practices. The Committee has proceeded on the21 assumptions that path of development will be determined by market and22 regulatory forces and that the Article 8 rules should not seek to influence that23 developmentin any specific.direction. In some respects, this makes the drafting.24 task that the Committee faces more challenging. Rather than writirig rules for25 anyone particular securities holding system, the Committee has attempted to26 devise a structure that, will continue to provide an adequate legal foundation for27 all of the securities holding systems now in use, and those that might evolve in28 the coming years. This approach does generate some complexity, but there29 seems to be no alternative that would avoid the risk of immediate obsolescence.

30 The principle of neutrality does carry some implications for the design31 of specific Article 8 rules. The Committee has attempted to identify and32 eliminate any Article 8 rules that might act as impediments to any of the33 foreseeable paths of development. At the very least, the Article 8 rules for all34 securities holding, systems should be sufficiently clear and predictable that35 uncertainty about the governing law does not itself operate as a constraint on36 market developrnents.,

37 Although,the Drafting Committee and Reporter considered various38 approaches to drafting a system of rules that could accommodate the variety of39 securities holding systems in use today, it became apparent early in the process,40 that the differences between the direct holding system and the indirect holding41 system are sufficiently significant that it is best to treat them as separate systems

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1 requiring different legal concepts. Accordingly, .while the rules of present2 Article 8 have, in large measure, been retained for the direct holding system, a3 new Part 5 has been added, setting out the cornmereial Iaw rules for the indirect4 securities holding system.

5 In addition to the changes in Article 8 itself, the statutory provisions on6 security interests in investment securities have been substantially revised. Thus,7 there are significant revisions in Article 9 as well as Article 8. The rules on8 security interests in investment securities have been taken out of Article 8 and9 placed in Article 9. This is a return to the organizational pattern of the pre-

10 1978 uec, which many commentators have recommended.

11 BO' .Direct Holding System

12 With respect to securities held directly, Revised Article 8 retains the13 basic conceptual structure and rules of present law. Thus, two significant14 categories of securities transactions will be relatively unaffected by the revision:15 (1) transactions involving securities issued by close corporations and (2)16 transactions in publicly traded securities held by investors who choose to hold17 their own securities, registered in their own names, rather than leaving them18 with their brokers or bank custodians. There are some changes in the19 organization of the provisions of existing law for the direct holding system, and20 some changes in substantive rules, but these changes are far less extensive than21 the revisions affecting the indirect holding system.' The change that is probably22 'most significant for securities held in the direct holding system is the revision of23 the rules on security interests. Even here, however, the Committee has24 endeavored to draft the new rules in such fashion that existing practices can be25 continued. The changes either provide additional methods of implementing26 secured transactions or facilitate transactions that are currently difficult to carry27 out.

28 CO' Indirect Holding System

29 1. How Present Law Treats the Indirect Holding System

30 The basic concepts of the present Article 8 rules are that an investor is31 treated as the owner of a security, and changes in ownership are described as32 transfers of a property interest in the security from the transferor to the33 transferee. The provisions of present law that deal with the indirect holding34 system endeavor to fit it into the same conceptual structure. A good example is35 the basic legal rule under which the depository system operates, Section 8-32036 of present law. Section 8-320 was added to Article 8 in 1962, at the very end37 of the process that culminated in promulgation and enactment of the original38 version of the Code, to take account of the depository system that was then in39 its infancy. The key concepts of the original version of Article 8 were "bona

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1 fide purchaser" and "delivery." Under Section 8-302 (1962) one could qualify2 as a "bona fide purchaser" only if one had taken a delivery of securities, and3 Section 8-313 (1962) specified what counted as a delivery. Section 8-320 was4 added to take account of the fact that in a depository system, no actual5 deliveries occur in settlement of trades. Rather than reworking the basic6 concepts, however, Section 8-320 brought the depository system within Article7 8 by definitional fiat. Subsection (a) of DeC § 8-320 (1962) stated that a8 transfer or pledge could be effected by entries on the books of a central9 depository, and subsection (b) stated that such an entry "has the effect of a

10 delivery of a security in bearer form or duly indorsed in blank. II In 1978,11 Section 8-320 was revised to conform it to the general substitution of the12 concept of "transfer" for "delivery," out the basic structure remained the same.13 Under the 1978 version of Section 8-320, a change in ownership of securities14 held through a clearing corporation is treated as a transfer of the security from15 one person to another, and the main point of Section 8-320 is to ensure that1(1 making appropriate entries on the books of a clearing corporation has the effect17 of transferring an interest in the security. .

18 In the 1.978 amendments, other provisions were added to deal with the19 indirect holding system at the level below the securities depositories. The most20 important was Section 8-313(1)(d). Section 8-313 of the 1978 version of Article21 8 sets out an exclusive list of the means by which an interest in a security can22 be transferred. Subsection (l)(d) of Section 8-313 is the provision dealing with23 investors who hold securities through a brokers or bank custodians. It operates24 in essentially the same fashion as Section 8-320, that is, it states that when a25 broker or bank which holds securities in fungible bulk makes entries on its26 books identifying a quantity of the fungible bulk as belonging to the customer,27 that action has the effect of transferring an interest in the security to the28 customer.

29 2. How Revised Article 8 Treats the Indirect Holding System

30 The starting point of Revised Article S's treatment of the indirect31 holding system is the concept of "securities entitlement. tI The term is defined in32 Section 8-102(a)(l6) as the package of rights that a person who holds securities33 through a securities intermediary has against that securities intermediary and the34 property held by that securities intermediary. The term "entitlement holder" is35 used to refer to a person who has a securities entitlement.

36 Structurally, the term "securities entitlement" is the analog for the37 indirect holding system of the term "security" for the direct holding system.38 The property interest of an investor who holds directly is a "security;" the39 property interest of an investor who holds in indirect form is a "securities40 entitlement. tI Like many legal concepts, however, the meaning of "securities

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1 entitlement" is to be found less in any specific definition than in the matrix of2 rules that use the term. In a sense, then, the entirety of Part 5 is the definition3 of "securities entitlement, It because the Part 5 rules specify the rights of those4 who hold securities entitlements.

5 Part 5 begins by specifying, in Revised Section 8-501, when an6 entitlement holder acquires a securities entitlement. Revised Section 8-501 takes7 the place of Section 8-313(1)(d) of present law, but is based on a different8 analysis of the transaction in which a customer acquires an interest in the9 indirect holding system. Under present law, the investor is treated as a

10 purchaser to whom an interest in a .security is transferred when the securities11 intermediary makes entries on its books reflecting that a quantity of securities12 held by the securities intermediary in fungible bulk now belong to the customer.13 Revised Section 8-501 takes a different approach. The transaction is not14 described as a "transfer" of an interest in some portion of a fungible bulk of15 securities held by the securities. intermediary, but as the creation of a package of16 rights against the securities intermediary; and an interest in the property held by17 the securities intermediary.

18 . The remaining sections of Part 5 specify the content of the securities19 entitlement concept. The Part 5 rules provide that a securities intermediary .20 must maintain a sufficient quantity of securities or securities entitlements to21 ~ satisfy all of its entitlement holders, and that to this extent the securities or22 securities entitlements are held by the intermediary for the entitlement holders23 and are not subject to general creditors claims. Thus, a securities entitlement is24 not merely an in personam claim against the intermediary. The concept of a25 securities entitlement does, however, include a package of in personam rights26 against the intermediary, and other Part 5 rules specify the core of this package27 of rights, leaving it to other law and regulation to fill in the details. The Part 528 rules cover such basic matters as the duty of the securities intermediary to pass29 through to entitlement holder the economic and corporate law rights of30 ownership of the security, including the right to receive payments, dividends,31 and distributions, and the right to exercise any voting rights. The Part 5 rules32 also specify that the securities intermediary has a duty to comply with33 authorized entitlement orders originated by the entitlement holder and to convert34 the entitlement holder's securities position into any other available form of35 securities holding that the customer requests, such as delivering a certificate or36 transferring the position to an account with another firm.

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1 III. SECURITY INTERESTS IN INVESTMENT PROPERTY

2 A. General Approach of New Security Interest Rules

3 Prior to the 1978 amendments, the rules on security interests in4 investment securities were part of Article 9. Since the general rules of Article 95 provided that no separate security agreement was needed for a possessory6 security interest, and that possession was an effective method of perfection, the7 Article 9 rules could accommodate the traditional pledge of investment8 securities, in which the debtor delivers the certificates to the secured party,9 thereby both creating the security interest and perfecting it. Various special

10 rules were included in the original version of Article 9 to accommodate certain11 limited situations where established practice recognized non-possessory security12 interests in securities, such as the provisions allowing a pledgee to return the13 securities to the debtor for a limited time to permit the debtor to present them14 for exchange in the event of a stock split, merger, or the like.

15 When the 1978 amendments provided for uncertificated securities, it16 became somewhat more difficult to fit all secured transactions involving17 securities into the general. Article 9 provisions on pledges. Rather than attempt18 to alter the Article 9 provisions on attachment and perfection by possession in19 such fashion that they might cover uncertificated securities, which by definition20 could not be pledged, the decision was made to move the provisions on

. 21 attachment and perfection from Article 9 to Article 8. Inasmuch as the Artic1e22 8 rules on transfer of ownership iriterest had already been altered to provide for23 both certificated and uncertificated securities, it seemed simpler to treat security24 interests in securities under Article 8, rather than to replicate the new Article 825 "possession equivalent" rules for uncertificated securities in Article 9. Doing so26 made it possible to treat security interests in uncertificated securities in the same27 fashion as security interests in traditional certificated securities.

28 The result was that the conceptual structure of the traditional possessory29 pledge remained the basis for security interests in securities, certificated or30 uncertificated, held directly or through securities intermediaries. Delivery could31 not, of course, be literally required for security interests in uncertificated32 securities, or for security interests in securities held by securities intermediaries,33 so the 1978 amendments substituted "transfer" for "delivery." The fundamental34 concept of the possessory pledge, however, was retained, so that a security35 interest could be created not simply by agreement, but by agreement coupled36 with a "transfer.".

37 The notion that a security interest in securities can be created only by a38 possessory pledge or some equivalent or substitute has become rather anomalous39 with the evolution of modem securities holding practices. The vast bulk of all

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1 securities holdings are now in book entry form of some sort, where ownership2 interests are evidenced only by notation on the books of depositories such as3 DTC and securities intermediaries such as broker-dealers and custodian banks.4 Article 8 recognizes that ownership interests can be created in such systems5 merely by book entries. It is, then, somewhat odd to insist that a security6 interest, as distinguished from an ownership interest, can be created only by7 some special act akin to the delivery of a certificate in the traditional possessory8 pledge.

9 This revision abandons the notion that a security interest in a security10 can be created only by a method akin to the traditional possessory pledge.11 Under the revised Article 9 rules, a security interest in securities can be created12 pursuant to Section 9-203 in the same fashion as a security interest in any other13 form of property, that is, by agreement between the debtor and secured party.14 There is no requirement of a "transfer," "delivery, \I or any similar action,15 physical or metaphysical, for the creation of an effective security interest. A16 security interest in securities is, of course, a form of property interest, but the17 only requirements for creation of this form of property interest under this draft18 are those set out in Section 9-203.

19 Once the requirement of a "transfer" for the creation of a security20 interest is dropped, the rationale for putting the rules on security interests in21 securities in Article 8 rather than Article 9 largely disappears. There is no need22 for the provisions, found in various subsections of Section 8-313 of present law,23 for special rules stating that acts sufficient to create security interests are24 deemed to be equivalent to II transfers. II Accordingly, this draft returns to the25 pre-1978 structure in which Article 9, rather than Article 8, sets out the rules on26 security interests in investment securities.

27 B. New Tenninology

28 The first change in the Article 9 rules made in this draft is a change of29 terminology to conform the Article 9 rules to the new structure of Article 8. A30 person who holds a security directly has a direct propeny interest in the31 security. The interest of a person who holds securities through a securities32 intermediary is described as a "securities entitlement." The conforming33 amendments to Article 9 define a new category of Article 9 collateral,34 "investment property," which includes both securities and securities35 entitlements. See Revised Section 9-115( l)(d). Corresponding changes to other36 Article 9 definitions are made to exclude investment property from the37 categories of "instruments" and "general intangibles. II Revised Sections38 9-105( l)(i) and 9-106.

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1 C. Attachment

2 Attachment of security interests in investment property is governed by3 Revised Section 9-203. Two mechanisms are possible: (1) execution of an4 ordinary Anicle 9 security agreement containing a description of the collateral,5 and (2) having the secured party obtain "control" over the investment property.6 The concept of "control" is used in various -provisions of Revised Article 8 and7 the corresponding Article 9 amendments. For purposes of the attachment rule,8 the main significance is that taking possession .of a certificated security counts as9 "control." Thus, as in present law, no-written security agreement is required

10 for attachment when the secured party has possession of certificated securities.

11 D. Perfection

12 Perfection of security interests-in investment property is governed by13 Revised Section 9-304(7) and (8). Revised Section- 9-304(8) deals secured14 financing of securities firms; Revised Section 9-304(7) is the general rule for15 security interests granted by persons oth-er than securities firms.

16 Revised Section 9-304(7) provides that if the debtor is not a securities17 intermediary, a security interest in its investment property can be perfected by18 filing, just as is the case for other forms ofproperty such as tangible goods or19 accounts. It should be noted, however, that Revised Section 9-304(7) is only a20 perfection rule. A secured party who relies on filing will not necessarily assure21 itself of priority over other secured parties. As an alternative- to filing, Revised22 Section 9-304(7) provides that a security interest can be perfected by the secured23 party obtaining "control." "Control" is defined in Revised Section 9-116. In24 rough form, the term means that the secured party has taken whatever steps may25 be necessary, given the manner in which the debtor holds the securities; to place26 itself in a position where it can, without the need for further acts by the debtor,27 have the securities sold. Because "control" includes taking possession of28 certificated securities, this perfection rule continues present law under which29 security interests in certificated securities can be perfected by possession. Other30 provisions of the Revised Section 9-116 definition of "control" cover other31 methods that are currently used to create and Perfect security interests under the32 guise of "possession. If Thus, this perfection rule makes it possible to implement33 such arrangements without concern over the uncertainties that result from34 forcing such arrangements into the concepts of "possession" drawn from35 common law pledge cases. Finally, subsection (l)(d) of Revised Section 9-11636 provides that when a security interest in a securities entitlement is granted by37 the entitlement holder to the securities intermediary itself, the intermediary is38 deemed to have control. The common scenario covered by this rule would be a39 margin loan from a broker to its customer. As is the case with many40 applications of the "control" concept, the effect of this rule is not to change the

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1 law, but to place on a sounder basis practices that currently rest on manipulation2 of the concept of possession;

3 Revised Section 9-304(8) deals with cases where a broker, securities4 intermediary, or commodity intermediary is the debtor, and grants a security5 interest in its investment property to a lender or other secured party. At6 present, the Draft sets out alternative versions; the Drafting Committee does not7 however intend to leave this matter to non-uniform choice by individual states,8 but plans to resolve the issue one way or the other in light of comments and9 suggestions from the securities industry, its lenders, and other interested parties.

10 Version 1 provides that a such a security interest is automatically perfected.11 This is not, as it may at first seem, a novel departure from existing rules.12 Rather, it is essentially a more clear statement of the actual current rules.13 Present law provides that a security interest in securities given for new value14 under a written security agreement is perfected without filing or possession for a15 period of 21 days. Securities firms can use this provision to obtain secured.16 financing for their inventory under so-called "agreement to pledge"17 arrangements. Though in legal theory the security interests are temporary, the18 financing arrangement can in practice be continued indefinitely by rolling over19 the loans at least every 21 days. The result is that any knowledgeable creditor20 of a brokerage will realize that the firm's securities may be subject to security21 interest that are not discoverable from any public records. Version 2 provides22 that a security interest granted by a broker, securities intermediary, or23 commodity intermediary is perfected if the firm has made entries on its books24 reflecting that the secured party has a security interest in the investment25 property in question. As explained in the Comment to Revised Section 9-304(8)26 this version is based upon non-uniform amendments to present law that were27 adopted in New York to provide a clearer legal basis for agreement to pledge28 financing than the 21-day automatic perfection rule.

29 E. Priorities

30 Revised Section 9-312(8) deals with priorities between contlicting31 security interests in investment property, It establishes several special priority32 rules for conflicting security interest in investment property. In cases not33 covered by one of these special rules, priority is determined by the general first34 in time of filing or perfection rule of Section 9-312(5). The principal priority35 rule is that a secured party who has obtained "control" has priority over a36 secured party who has not done so. For example, a secured party who perfects37 a security interest in a certificated security by filing would lose to a later38 secured party who obtained possession. Similarly a secured party who perfects39 a security interest in a debtor's securities entitlements by tiling would lose to a40 later in time secured party who obtained a tri-party agreement under which the41 intermediary agreed to act on the secured party's instructions.

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1 F. Application of Revised Article 9 Rules

2 1. New Arrangements for Security Interests in Certificated Securities3 Made Possible by the Revision.

4 Under present law, the possessory pledge is the only realistic option5 available to a person who holds securities in the ordinary certificated, direct6 form and wishes to use them as collateral for a loan. In many situations the7 debtor might prefer to retain possession, but that. is not feasible today even if8 the lender would otherwise be willing to accept the consequent risks of debtor9 misbehavior. For the secured party to have a perfected security interest, it must

10 take possession. In effect, the lender who trusts the debtor's honesty, but has11 reservations about the debtor's credit standing, is prevented by the legal rules12 from adopting an arrangement that fits the parties assessments of the risks. The13 only way to protect against credit risk is to take the step necessary to protect14 against honesty risk -- take the collateral out of the debtor's hands. For other15 forms of personal property, the Article 9 rules permit the lender and debtor to16 implement more precisely tailored arrangements. Perfection can be achieved by17 filing. Protection against debtor misbehavior can, if desired, be achieved by18 taking possession or other policing techniques. This revision makes these same19 choices available to debtors and lenders with respect to securities. A lender20 who is otherwise willing to leave the collateral in the debtor's hands can perfect21 by filing a financing statement. If that risk is thought unacceptable, the lender22 can take possession.

23 The option of .perfection by filing may also be useful in circumstances24 where the lender wishes to take possession of the securities, but is willing to25 return them to the debtor for some limited or temporary purpose, such as26 exchange, registration of transfer, or the like. Under present law, Section27 9-304(5) permits a secured lender to return securities to the debtor, without28 losing perfected status, but only for a period of 21 days. Under the revision a29 lender in that situation could file a financing statement to assure itself of30 perfection in the event that it took more than 21 days to carry out the31 transaction involved.

32 2. Security Interests in Securities Held by Investors Through Financial33 Intermediaries.

34 One of the objectives of the revision is to facilitate, to as great an35 extent as is practicable, transactions in which investors wish to use their36 securities positions held though securities intermediaries as collateral for loans.37 The revision eliminates all of the obstacles to such arrangements that result from38 the uncertainties of present law. Under Revised Article 8, a person who holds39 securities through an account with a broker or custodian has a securities40 entitlement. The proper perfection methods for securities entitlements are stated

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1 specifically in Revised Section 9-304. If the debtor is not a securities2 intermediary, the secured interest can be perfected by filing a financing3 statement or by "control." Two methods of obtaining control are possible.4 First, the secured party could be designated as the entitlement holder, or, to put5 it colloquially, the securities in the account could be transferred outright to the6 secured lender on the books of the debtor's securities intermediary or some7 other intermediary with whom the secured party has an account. Revised8 Section 9-1 16(1)(c)(i). Second, if the securities intermediary is willing to enter9 into an explicit agreement in which it agrees to act on the directions of the

10 secured party, the secured party obtains control under Revised Section11 9-116(1)(c)(ii) even though the debtor remains listed as the entitlement holder12 and retains the right to trade the securities in the account.

13 The revision also clarifies the law concerning secured financing of14 securities firms. The rules of the revision facilitate this financing by treating15 the security arrangements in a fashion consistent with the general Article 916 concepts that have proved workable for inventory financing in other industries.17 The pledge model of present law requires these transaction to be structured as if18 they were individual, one-shot transactions involving specific items of property.19 Under the revision, the legal framework can be the same as for other' forms of20 inventory financing. An ordinary written security agreement suffices for21 attachment; the collateral can be described, in whatever fashion or detail suits22 the arrangement. In the securities industry, unlike other businesses, it is23 common for firm to establish arrangements with several lenders, and to grant to24 specific lenders security interests in specific collateral. Under this revision,25 these arrangement can easily be implemented as a matter of the description of26 the collateral in the agreement or supplementary listings. The secured party27 who relies on such an arrangement does, of course, take the risk that the debtor _28 will double finance, and do so in a fashion that gives the other lender priority.29 If the lender finds that risk excessive, it can require the debtor to take the steps30 necessary to give the lender control, and thereby obtain the benefit of the31 priority rule of Revised Section 9-312(8).

32 For individual investors, the rules of this revision eliminate legal33 uncertainties that operate as obstacles to the use of securities held through34 securities intermediaries as collateral for third party loans. There is, however,35 probably nothing that legal rules can do to place all possible lenders on a36 completely even playing field. The broker through whom a person holds37 securities has the inherent advantages as a lender. It knows at all times exactly38 what the investors securities position is and can protect against risk of debtor39 misbehavior at essentially no additional cost. There is, however, a question of40 policy in the choice of priority rules to govern situations where an investor41 borrows from and grants a security interest to both to a third party and to the42 broker. In order to facilitate the ability of investors to use their securities

A-23

1 accounts entitlements as collateral for loans from other lenders, one could try to2 design a priority rule that made it possible for an independent lender to obtain a3 first priority security interest that would not be subordinated to any security4 interests that the investor might latter grant to the securities intermediary.5 Adopting such a rule, however, might impair the ability of investors to obtain6 margin financing, or even conduct ordinary dealing with their brokers, such as7 paying by check for securities that they have purchased, because brokers would8 have to investigate to assure themselves that no prior liens had been created in9 the investors securities entitlements. Revised Section 9-312(8) takes the

10 approach of conferring certainty on the broker's position. It provides that a11 security interest granted by an entitlement holder to the securities intermediary12 has priority over any security interests. granted to other parties, except where the13 broker has allowed the debtor to transfer the securities outright to another14 secured party.

15 G. Special Provisions on Registered Pledge Unnecessary

16 . One consequence of adopting the "security interest structure of this17 revision, is that it becomes unnecessary to have special statutory provisions for18 registered pledges of uncertificated securities. The reason that the 1978 version19 of Article 8 created this concept was that if the only means of creating security20 interests was the pledge, it seemed necessary to provide some substitute for the"2! pledge when one eliminated the certificate. The point of the registered pledge22 Is, presumably, that it permits a debtor to grant a perfected security interest in23 securities, yet still keep' the securities in the debtor's own name for purposes of24 dividends, voting, and the like. The concept of registered pledge has, however,25 been thought troublesome by many legal commentators and securities industry26 participants. For example, in Massachusetts, where many mutual funds have27 their headquarters, a non-uniform amendment was enacted when the 197828 amendments were adopted, to permit the issuer of an uncertificated security to29 refuse to register a pledge, instead issuing a certificate to the owner that the30 owner could then pledge by ordinary means.

31 Under present Article 8, if an issuer chooses to issue securities in32 uncertificated form, it must also offer a registered pledge program. Revised33 Articles 8 and 9 take a different approach. All of the provisions dealing with34 registered pledges have been deleted. This does not mean, however, that35 issuers cannot offer such a service. The rules of Revised Section 9-11636 concerning "control," and the related priority provisions, establish a structure37 that permits issuers to develop systems akin to the registered pledge device,38 without mandating that they do so, or legislating the details of the system.39 Experience in the indirect holding system suggests that the approach of leaving40 this matter to private arrangements is feasible. DTC, for example. offers its41 participants a service akin to the registered pledge device. By agreement among

A-24

1 DTC, the debtor, and the secured party, DTC will set up a pledge account into2 which the debtor can have securities transferred as collateral for loans from the3 secured party. DTC will hold the securities in the pledge account subject to the4 instructions of the secured party. In essence, the DTC pledge program really5 amounts to a record keeping service. If the parties wish to pay DTC for the6 service, DTC will keep track of which securities the secured party holds for its7 own account outright, and which securities it holds in pledge from its debtors.8 If the parties do not want that record keeping service, they can have the9 securities transferred to the secured party outright, and the secured party can

10 keep it own records about the capacity in which it holds the securities in its11 . DTC account.

12 Under the rules of this revision, the registered pledge question can13 easily be left to resolution by the market. The concept of control is defined in14 such fashion that if an issuer or securities intermediary wishes to offer a service15 akin to the DTC pledge program it can do so. The issuer or securities16 intermediary would offer to enter' into agreements with the debtor and secured17 party pursuant to which it will hold the securities for the account of the debtor.18 but subject to instructions from the secured party. The secured party would19 thereby obtain control assuring perfection and priority of its lien.

20 Even if such arrangements are not offered by issuers, persons who hold21 uncertificated securities will have several options for using them as collateral for22 secured loans. If the .debtor is a broker the secured party can rely on the .23 [automatic perfection / book-marking] rule of Revised Section 9-304(8). If the24 debtor is not a broker, the secured party can perfect by filing a financing25 statement under Revised Section 9-304(7). Either of these methods does, of26 course, leave the secured party exposed to the risk that the debtor will double27 finance and grant a latter secured lender a security interest under circumstances28 that give that lender control and hence priority. If the lender is unwilling to run29 that risk, the debtor can transfer the securities outright to the lender on the30 books of the issuer, though between the parties the debtor would be the owner31 and the lender only a secured party. That, of course, requires that the debtor32 trust the secured party not to dispose of the collateral wrongfully, and the debtor33 may also need to make arrangements with the secured party to exercise benefits34 of ownership such as voting and receiving distributions.

35 .It may well be that both lenders and borrowers would prefer to have36 some arrangement, such as the registered pledge device of current law, that37 permits the debtor to remain as the registered owner entitled to vote and receive38 dividends but give the lender the power to prevent the debtor from disposing of39 the securities and to itself order their disposition. The approach taken in this40 revision is that if there is a genuine demand for such arrangements. it can be41 met by the market. Debtors and lenders would presumably have to pay for the

A-25

1 service, since it imposes record keeping and other administrative costs on the2 issuers, but there is no obvious reason why they should not pay for such3 services. The difficulty with the approach of-present Article 8 is that it4 mandates that any corporation that wishes to .issue securities in uncertificated5 form must also offer this record"keeping service. That obligation may well act6 as a disincentive to the development of uncertificated securities. Thus, the7 deletion of the mandated, registered,pledge provisions is consistent with the8 principle of neutrality toward the; evolution of.securities holding practices.

9 IV. NOTE ON THE TERMINOLOGY AND10 CONCEPTS OF REVISED ARTICLE 8

11 A. Ambiguity-of "Security"

12 Although Revised Article 8 adopts new terminology and a new13 conceptual structure for describing the interests of person who holds securities14 through securities intermediaries, the new commercial law rules will not require15 wholesale changes in terminology or approach to transactions involving16 securities. To see why, it may be useful to analyze a simple scenario:

17 Suppose that Sally and Betty 'are each interested in investing in the18 common stock of XYZ Co~ They each go to their respective brokers and place19 an .order to purchase 1000 shares of XYZ Co common stock. Sally tells her20 broker that she wishes to receive a certificate evidencing her investment. Betty21 tells her broker thatshe wishes to hold her investment in an account with the22 broker. Both transactions are executed. Sally receives a certificate showing23 that she is the registered owner of 1000 shares, and Betty receives a statement24 from her broker showing that 1000 shares have been credited to her account.25 For most purposes, the difference in the ways that Sally and Betty have chosen26 to hold their investment in XYZ Co common stock is irrelevant. For example,27 if called upon to produce financial statements in connection with obtaining28 loans, each could truthfully report that she is the owner of 1000 shares of XYZ29 common stock. The difference between their situations is not that they have30 chosen to invest in different assets, but that they have chosen different ways of31 investing in the same asset.

32 If it were possible to start from scratch in terminology, there would be33 much to be said for using one set of terms to refer to the underlying asset and a34 different set of terms to refer to 'the way In.which that asset is held. We might,35 for example, say that although the underlying asset that Sally and Betty own is36 "1000 shares of XYZ common stock," Sally's evidence of her share ownership37 is a "securities certificate," while Betty's 'evidence of her share ownership is a38 "securities entitlement. It However desirable a terminological convention such as

A-26

1 this might be, the drafters of statutes -. arid even more so the revisers of2 statutes -- must accept usage as they find It. Unfortunately for these purposes,3 existing usage of the term "security" blurs the distinction between the4 underlying asset and tile evidence of ownership. With respect to shares5 represented by certificates, the term "~urity" has long been used to refer both6 to the intangible interest and the certificate, and Article 8 explicitly sanctions7 this ambiguity. In the em when all "securities" -.. in the sense of the underlying8 assets governed by Article 8 -- were represented by certificates, this ambiguity9 was not a significant problem. As other means of evidencing ownership have

10 developed, such as uncertificated direct holdings and holdings through11 intermediaries, the ambiguity becomes more troublesome. It would, however,12 probably be futile for Article 8 to attempt to force lawyers and business people13 to change usage in order to facilitate discussion of the issues governed by14 Article 8. Accordingly, Revised Article 8 accepts as inevitable that the term15 "security" is used in different senses. It may, however, be useful to note16 explicitly the ways in which terms are being used in asenses that are potentially17 confusing.

18 Beginning with the forms of investment interests that are the core19 concern of Article 8, such as corporate stocks and bonds, we have the following20 possibilities:

21

2223

Underlying Asset

Share of common stock("Security")

Evidence of Ownership

Stock certificate("Security")

24 Registration on the books of the issuer25 as owner of uncertificated share26 ("Security")

27 Entries on the books of an28 intermediary ("Securities Entitlement")

29 In common usage,the underlying asset -.. the share of common stock -- is30 referred to as a "security," and Article 8 accepts that usage. A person who31 owns such a "security" might chose to hold that "security" in three different32 ways: (1) take possession of a certificate; (2) become the registered owner of33 shares in uncertificated form (if the issuer offers uncertificated shares); or (3)34 hold the shares through an account with an intermediary. Revised Article 835 follows present usage and law in using the term II security" to refer to the first36 two of these three forms in which an investor might hold the underlying asset.37 That is, a person whose interest in the underlying asset is evidenced by

1 possession of a certificate or by registration on the books of the issuer is2 described as the "holder" of a "security." Thus, in these cases the term3 "security" is being used to refer both to the underlying asset and to the form of4 evidence of ownership. Revised Article 8 changes terminology only with5 respect to the third form of evidence of ownership. Under Present Article 8, a6 person whose ownership of shares of common stock is evidenced by entries on7 the books of an intermediary is described as a "purchaser" of an interest in "a

. 8 security," just as a person whose ownership of shares of common stock is9 evidenced by physical possession of a certificate is described as a "purchaser" of

10 an interest in "a security. It Under Revised Article 8, by contrast, a person11 whose ownership of shares of common stock is evidenced by entries on the12 books of an intermediary is described as having a "securities entitlement."

13 Thus, if one asks whether a person who has a securities entitlement is14 the "owner of a security" the answer is yes or no depending on the context. If15 the focus-of the discussion is the underlying asset, it is perfectly natural to say16 that a person who has a securities entitlement is the "owner of a security." If17 the focus of the discussion is the evidence of ownership, it is inappropriate to18 describe the person as the "holder." of a Itsecurity"; instead one should describe .19 the person as having a securities entitlement.

20 To illustrate the varying contexts in which the term "security" might be21 used, consider a simple transaction. Suppose that Sally enters into a contract to22 sell 1000 shares of XYZ Co .common stock to Betty. Sally's performance23 obligation under the sales -contract is to take the appropriate steps to place Betty24 in the position where Betty has the package of rights and interests against XYZ25 Co that constitute ownership of common stock. Sally might perform her26 obligation in various ways, such as the following:

27 Case 1. Suppose that both Sally and Betty prefer to hold their securities in28 certificated form. Sally has a certificate evidencing that she is the29 registered owner of 1000 shares of XYZ Co. stock. She could perform her30 obligation under the sales contract by delivering the certificate to Betty with31 proper indorsement or stock power. Betty could then have the transfer32 registered by the issuer and obtain a certificate evidencing that she is the33 registered owner of 1000 shares of XYZ 'Co, stock.

34 Case 2. Suppose that Sally holds her securities through an account at her35 broker, Able & Co., but Betty prefers to hold her securities in certificated36 form. Sally has no certificate that could be delivered to Betty, so she must37 satisfy her performance obligation under the sales contract in some other38 way, as, for example, by directing her broker Able & Co. to debit her39 account for the 1000 shares and cause the necessary book entries to be40 made, ordinarily through a clearing corporation. so that XYZ Co. 's transfer

A-28

1 agent will issue a certificate to Betty evidencing that Betty is the registered2 owner of 1000 shares of XYZ Co. stock.

3 Case 3. Suppose Sally holds her securities through an account at her4 broker, Able & Co., and Betty holds her securities through an account at5 her broker, Baker & Co. Sally can satisfy her performance obligation6 under the sales contract by directing her broker to debit her account for7 1000 shares of XYZ Co. stock and cause the necessary book entries to be8 made so that Betty's broker will credit Betty's account for 1000 shares of9 XYZ Co. stock.

10 The subject matter of the sales contract is the underlying asset -- the 100011 shares of XYZ Co. common stock. Accordingly, it would be perfectly natural12 to describe any of these transactions as contracts for the sale of "a security, II

13 using that term to refer to the underlying asset.

14 The difference among these three cases is a matter of how the parties15 chose to evidence their ownership of the underlying asset. The difference in the16 means of evidencing ownership does mean that a different terminology is17 required in analyzing how the contract for sale was settled. Analysis of18 settlement requires that we focus on how each party chose to evidence her19 ownership and how the circumstances were changed so that Betty, rather than20 Sally, would have evidence of ownership. Under Revised Article 8, the steps21 would be described as follows:

22 Case 1. Sally was the holder of a certificated security. She transferred23 that security to Betty by giving Betty physical possession of the certificate,24 along with a proper indorsement. Thereupon Betty became the holder.25 Upon registration of the transfer by the issuer, Betty became the registered26 owner.

27 Case 2. Sally was not the holder of a security; rather she had a securities28 entitlement to 1000 shares of XYZ Co. common stock. She initiated an29 entitlement order to her securities intermediary, Able & Co., directing that30 Able & Co. dispose of her securities entitlement by debiting her account for31 1000 shares and causing the appropriate entries to be made so that XYZ32 Co. 's transfer agent would issue a certificate to Betty. In the usual case,33 Able & Co. would have carried out this entitlement order by in turn34 initiating an entitlement order to Able & Co. 's securities intermediary,35 DTC, directing DTC to dispose of Able & Co. 's securities entitlement to36 1000 shares by debiting Able & Co.'s account for 1000 shares and causing37 the appropriate entries to be made so that XYZ Co. 's transfer agent would38 issue a certificate to Betty. DTC was the registered owner of a security. so39 DTC can instruct XYZ Co. 's transfer agent to transfer 1000 shares to

A-29

1 Betty. When the transfer agent does so, Betty becomes the holder of a2 security.

3 Case 3. Sally was not the holder of a security; rather she had a securities4 entitlement to 1000 shares of XYZ Co. common stock. She initiated an5 entitlement order to her securities intermediary, Able & Co., directing that6 Able & Co. dispose of her securities entitlement by debiting her account for7 1000 shares and causing the appropriate entries to be made so that Baker &8 Co. would creditBetty's account for 1000 shares. In the usual case, Able9 & Co. would have carried out this entitlement order by in tum initiating an

10 entitlement order to Able & Co. 's securities intermediary, DTC, directing11 DTC to dispose of Able & Co. 's securities entitlement to 1000 shares by12 debiting Able & Co. 's account for 1000 shares and crediting Baker & Co. 's13 account. When pTC does so, Baker & Co. acquires a securities14 entitlement against DTC to 1000 shares of XYZ. When Baker & Co..15 credits Betty's account, Betty 'acquires asecurities entitlement against Baker16 & Co. to 1000 shares of XYZ.

17 In this analyses, the terms "security" and "securities entitlement" refer to the18 evidence of ownership, rather than to the underlying assets. Accordingly it is19 necessary to distinguish between being the "holder of a security" and "having a20 securities entitlement. "

21 It is, however, worth bearing in mind that in many, if not most, legal22 contexts, the difference in the Article 8 analysis of various mechanisms of23 settlement of a sales corrtract is essentially irrelevant. Suppose, for example,24 that Betty bought the XYZ Co. stock at a time when the price was rising in25 response to misleadingly positive earnings reports issued by XYZ Co. Betty26 brings an action against officers of XYZ Co. alleging violations of the Federal27 securities laws. Betty would obviously have satisfied the "purchaser"28 requirement for bringing an action under Rule 10b-5; the differences among29 Cases 1, 2, and 3 concerning how the transaction between Sally and Betty had30 been settled are irrelevant. In this context, what "purchaser" means is a person31 who has given- value to acquire the package of corporate law rights that32 comprise ownership of XYZ Cop. common stock. To take another example,33 suppose that Sally contends that Betty committed some form of fraud that34 induced Sally to enter into the sales contract and therefore Sally has the right to35 rescind or recover damages. H-ere too, it makes no difference how Sally36 performed the obligation she incurred in the sales contract; what matters is that37 Betty induced Sally by fraud to part with her 1000 share position in XYZ Co.38 . stock. Since there are no legal issues about the way in which the parties held39 their shares, or how the contract for the sale was settled, there is no need to go40 through the precise Article 8 analysis. Accordingly it would be pedantic to41 insist that locutions such as "Sally transferred 1000 shares to Betty," or "Betty

1 bought 1000 shares of XYZ from Sally," could appropriately be used only if the2 transaction had been settled as in Case 1 and that in the other cases one must3 speak of Sally having initiated an entitlement order with respect to her securities4 entitlement, or Betty having acquired a securities entitlement in reliance upon5 misleading financial information.

6 In other legal contexts it is important to distinguish among various7 means of evidence of ownership, and thus it is becomes essential to go through8 the analysis of the transaction under the new terminology of Revised Article 8.9 Suppose for example.that Debbie owns 1000 shares of XYZ Co. stock and

10 wishes to borrow money from Carol using her XYZ Co. stock as collateral for11 the loan. The secured transaction. might be implemented in a variety of ways:

12 Case 4. Suppose that Debbie had a certificate evidencing that she was the13 registered owner of 1000 shares .of XYZ Co. stock. She could deliver the14 certificate to Carol with proper indorsement or stock power.

15 Case 5. Suppose that Debbie holds her securities through an account at her.16 broker, Able & Co., and that Carol also has a securities account at Able &17 Co. Debbie could instruct Able & Co. to transfer 1000 shares of XYZ Co.18 stock from her account to Carol's account.

19 Case 6. Suppose that Debbie holds her securities through an account at her20 broker, Able & Co., and that Carol has a securities account at Baker ~ Co.21 Debbie could instruct Able & Co. to transfer 1000 shares of XYZ Co. stock22 from her account to Carol's account at Baker & Co.

23 Each of these three cases could be described as ones in which Debbie granted a24 security interest to Carol in her position in XYZ Co. common stock, so that25 Carol then had an interest as secured party in 1000 shares XYZ Co. common26 stock position. Indeed, if one uses the term "security" to refer to the underlying27 asset rather than to the evidence of ownership, one could describe each of these28 cases as ones in which Debbie granted Sally a security interest in a "security."29 That usage, however, is likely to generate confusion, because the precise means30 in which the transaction was implemented is often significant in analyzing31 secured transactions. In particular, if one asks whether Carol's security interest32 is "perfected," one is asking a question about whether the appropriate steps have33 been taken to implement the creation in Carol of an interest in the 1000 shares34 XYZ Co. common stock position. That is precisely the sort of question where35 it matters how the parties chose to hold the underlying asset. The analysis36 under Revised Articles 8 and 9 would be as follows:

37 Case 4. Debbie's ownership interest in 1000 shares of XYZ Co. stock was38 evidenced by a certificate showing her as registered owner. Under Article

A-31

1 8 she is treated as the holder of a security. She granted a security interest2 to Carol in her 1000 share position in XYZ Co. stock. The secured3 transaction was implemented by delivery of the certificate. Carol's security4 interest is perfected because Carol obtained physical possession of the5 certificate..See §§ 9-116(1) and 9-304(7). While Carol has possession, she6 is the holder and Debbie is not the holder. As between Debbie and Carol,7 however, Debbie is the owner and Carol is a secured party; that is Carol is8 the holder of the security, but she holds it as secured party rather than9 outright owner. Thus, if Debbie repays the debt, Carol is obligated to

10 return the collateral to Debbie.

11 Case S. Debbie's ownership interest in 1000 shares of XYZ Co. stock was12 evidenced entries on the books of Able & Co. Under Article 8 she is not13 treated as the holder of a security, but as having a securities entitlement14 against Able & Co. to 1000 shares of XYZ Co. stock. She granted a15 security interest to Carol in "her 1000 share position in XYZ Co. stock.16 The secured transaction was implemented by having Able & Co. debit17 Debbie's account and credit Carol's account. Carol's security interest is18 . perfected because Carol became the entitlement holder having a securities19 entitlement against Able & Co. to 1000 shares of XYZ Co. stock. See20 §§ 9-1 16(1)(c)(i) and 9-304(7). Carol, not Debbie, is now the entitlement21 holder. As between Debbie and Carol, however, Debbie is the owner and22 Carol is a secured party; that is Carol is the entitlement holder, but she has23 the securities entitlement as secured party rather than outright owner,24 Thus, if Debbie repays the debt, Carol is obligated to return the collateral25 to Debbie.

26 Case 6. Debbie's ownership interest in 1000 shares of XYZ Co. stock was27 evidenced entries on the books of Able & Co. Under Article 8 she is not28 treated as the holder of a security, but as having a securities entitlement29 against Able & Co. to 1000 shares of XYZ Co. stock. She granted a30 security interest to Carol in her 1000 share position in XYZ Co. stock.31 The secured transaction was implemented by debiting Debbie's account at32 Able & Co., crediting Carol's account at Baker & Co., and making33 appropriate adjustments in Able and Baker's accounts at DTC. Carol's34 security interest is perfected because Carol became the entitlement holder35 having a securities entitlement against Baker & Co. to 1000 shares of XYZ36 Co. stock. See §§ 9-1 16(1)(c)(i) and 9-304(7). Carol, not Debbie, is now37 the entitlement holder. As between Debbie and Carol, however, it remains38 the case that Debbie is the owner of the 1000 XYZ position, and Carol's39 interest is that of a secured party; that is Carol is the entitlement holder, but40 she has the securities entitlement as secured party rather than outright

1 owner. Thus, if Debbie repays the debt, Carol, is obligated to return the2 collateral to Debbie.'

3 Although precision in the usage of the new terminology will often be4 important in discussion of security interests in investment property, this will not5 always be the case. Suppose, for example, a dispute arises about whether6 Debbie is in default, or whether Carol has acted in a proper fashion in disposing7 of the collateral after default. The method of perfection would not matter, so8 there would be no need to distinguish among Cases 4, 5, and 6. Rather, it9 would be entirely natural to describe these simply as cases in which Debbie

10 granted Carol a security interest in 1000 shares of XYZ common stock.

11 B. Application of Indirect Holding System Rules12 to Financial assets other than "Securities"

13 As is explained in the Comment to Section 8-104, the new indirect14 holding system rules of Part 5 of Revised Article 8 apply to a broader class of15 property than "securities" in the narrowest sense. For example. the depository16 system that has evolved for stocks and bonds also provides an efficient means of17 recording and· transferring interests in money market instruments, such as18 commercial paper, bankers acceptances, and certificates of deposit. Revised19 Section 8-102(a)(11) defines a new term "financial asset" to refer to a broad20 class of property that might be held through intermediaries. Although the rules21 of Parts 2, 3, and 4 of Article 8 would not apply to, financial assets that do not22 also fall within the narrower definition of "security" in Section 8-102(a)(18), the23 indirect holding system rules of Part 5 would apply to this broader class, insofar24 as they are held through intermediaries.

25 The expansion of the indirect holding system rules beyond the narrow26 category of traditional investment securities adds another dimension to the27 terminological problem. As was noted above, there are various forms of28 evidence of ownership of the underlying assets that fall within the narrow29 definition of "security." One of these means of evidencing ownership -- the30 "securities entitlement" -- can be used even for underlying assets that do not fall31 within the narrow definition of "security." An expanded version of the table32 presented above may aid understanding:

33 1 It should be noted that Cases 4, 5. and 6, do not represent a complete listing of the34 means of perfection. They are discussed here only for purposes of illustrating general points35 about the new terminology of Revised Articles 8 and 9. The specifics of the rules on36 perfection are explained in the Comment to Sections 9-116 and 9·304.

A-33

1

23

456

78

910

. 1112

Underlying Asset

Share of common stock("Security")

Money market instrument, e.g.bankers acceptance (rt Article 3Negotiable Instrument": "Financialasset")

Evidence of Ownership

Stock certificate("Security")

Registration on the books of. the issueras owner of uncertificated shareC'Security")

Entries on the books of anintermediary (ltSecurities Entitlement")

Possession of writing embodyingobligation (ItArticle 3 NegotiableInstrument")

13 Entries on the books of an14 intermediary C'Securities Entitlement")

15 A money market instrument, such as a bankers acceptance, remains an Article 316 negotiable instrument; it would not be treated 4S a It security" under Section17 8-102(a)(l8). Thus, Article 3, rather than Article 8, would provide the18 governing law on the obligations of the immediate parties, such as the19 obligations of an acceptor, the mechanics of presentment, and the rights of a20 person having- possession of the written instrument. One the other hand, if a21 money market instrument is held by a clearing corporation, the rights of the22 clearing corporation's participants with respect to that money ,market instrument23 would be governed by Part 5 of Article 8., In contexts where the means of24 evidence of ownership is significant, the interests of the participants would be25 described as "securities entitlements" to the money market instrument.

26 The complexity in the terminology of Revised Article 8 is regrettable,27 yet no simple solution is apparent. The heart of the difficulty is the ambiguity28 that is well-entrenched in current business and legal usage -- the term "security"29 is used both to refer to the underlying asset and the certificates that are the30 traditional means of evidencing ownership. Unless the term "security" is to be31 abandoned altogether, or given a restrictive definition at odds' with common32 usage, one must live with that ambiguity. The key to the new Article 833 terminology may be to remember a basic point. No one would care about34 possession of stock certificates but for the fact that legal rules and commercial35 practice make possession of certificates significant for purposes of determining36 rights to shares of common stock. Neither tI securities certificates \I nor

1 "securities entitlements" are ends in themselves; they are means to an end --2 enjoyment of the package of economic and corporate rights that comprise3 ownership of common stock or other investments.

4 V. TABLE OF DISPOSITIONS OF SECTIONS5 IN FORMER ARTICLE 8

6

789

10111213141516171819202122232425262728293031323334353637383940

Article 8 (1978)

8-1018-102(1)(a) & (b)8-102(l)(e)8-102(l)(d)8-102(1)(e)8-102(2)8-102(3)8-102(4)8-102(5)8-102(6)8-1038-1048-105(1)8-105(2)8-105(3)8-1068-1078-1088-2018-2028-2038-2048-2058-2068-2078-2088-3018-3028-3038-304(1)8-304(2)8-304(3)8-3058-306(1)

A-35

Revised Article 8 and 9

8-1018-102(a)(18)8-1058-102(a)(l4)8-102(a)(2)8-202(b)(3)8-102(a)(5)omitted8-102(b) & (e)8-102(d)8-2098-2108-116omitted8-1178-112omittedomitted8-2018-202 .8-2038-2048-2058-2068-2078-2088-3018-3028-102(a)(3)8-108(c) & 8-304(b)omitted8-108(a)8-108(b)8-109(c) & (e)

123456789

1011121314151617181920212223242526272829303132333435363738394041424344

8-306(2)8-306(3)8-306(4)8-306(5)8-306(6)8-306(7)8-306(8)8-306(9)8-306(10)8-3078-308(1)8-308(2)8-308(3)8-308(4)8-308(5)8-308(6)8-308(7)8-308(8)8-308(9)8-308(10)8-308(11)8-3098-3108-311(a)8-311(b)8-312(1)8-312(2)8-312(3)8-312(4)8-312(5)8-312(6)8-312(7)8-312(8)8-313(l)(a)8-313(l)(b)8-313(l)(c)8-313(l)(d)8-313(1)(e)8-313(1 )(t)8-313(1 )(g)8-313(1 )(h)-(j)

8-313(2)

A-36

8-109(a)8-109(g)8-109(h)8-109(d)8-308(c)8-109(b) & 8-307(d) & 8-308(c)omittedomitted8-109(i)8-305(e)8-102(a)(l2)8-305(b)8-305(c)8-102(a)(13)8-102(a)(13)8-106(a)(1)8-106(a)(2)8-106(b)8-305(a) & 8-3068-106(c)8-106(d)8-305(d)8-305(f)8-407omitted8-307(a)8-307(b)8-308(b)8-307(c)8-308(a)8-308(c)omitted8-307(d) & 8-308(c)8-303(a)8-303(b)8-303(c)omitted, see 8-5018-303(d)8-303(e)omitted, see 8-501omitted, see 9-116, 9-203,9-304(7) & (8)omitted, see 8-102(b) & (c),8-503

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10111213141516171819

) 20.2122232425262728293031

8-313(3)8-313(4)8-3148-3158-3168-3178-3188-3198-3208-321

8-401(1)(a)-(b)8-401(l)(c)8-401(l)(d)-(e)8-401(2)8-402(1)8-402(2)8-402(3)8-402(4)8-4038-404{1)8-404(2)8-404(3)8-405(1)8-405(2)8-405(3)8-406(l)(a)8-406(1)(b)8-406(2)8-4078-408

A-37

omitted8-102(a)(17)omittedomitted8-3098-1118-310omitted, see 8-114omitted, see 8-501omitted, see 9-116, 9-203,9-304(7) & (8)8-401(a)(2)-(3)omitted8-401(a) (4)-(5)8-401 (b)8-402(a)8-402(b)8-402(c)omittedomitted, see 8-403(a)(2) & 8-403(c)8-403(c)8-403(b)8-403(b)8-405(a)8-404 (a)8-404(b)omitted8-406omittedomittedomitted, see 8-405(b)